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1988
Introduction [to The Conflict Between Equilibrium
and Disequilibrium Theories]
Richard E. Quandt
Princeton University
Harvey S. Rosen
Princeton University
Citation
Quandt, Richard E., and Harvey S. Rosen. 1988. "Introduction." In The Conflict Between Equilibrium and Disequilibrium Theories:
The Case of the U.S. Labor Market. Kalamazoo, MI: W.E. Upjohn Institute for Employment Research, pp. 1-6.
http://research.upjohn.org/up_bookchapters/111
This title is brought to you by the Upjohn Institute. For more information, please contact [email protected].
Introduction
1.1 The Policy Issues
In 1985, the unemployment rate in the United States was 7.1
percent. There is virtual agreement that unemployment of this magni
tude is a serious problem both for the individuals involved and for
society as a whole. Workers who lose their jobs bear an immediate
financial loss which can be substantial even in the presence of
unemployment insurance. Even after a spell of unemployment is
completed, an individual may continue to feel its economic effects.
Future earnings may be less because of missed opportunities for
on-the-job training and other kinds of investment in "human capital."
From the point of view of the economy as a whole, perhaps the best
way to summarize the impact of unemployment is its cost in foregone
output. In 1985, for example, the difference between actual Gross
National Product and potential Gross National Product was roughly
$110 billion or 2.75 percent of actual GNP. 1 Finally, we should note
that unemployment appears to be related to a number of individual and
social problems whose costs are hard to quantify there is some
evidence, for example, that when unemployment goes up, so do heart
disease, crime, mental illness, and even suicide. 2
This monograph discusses several approaches to the analysis of
unemployment, and public policy to deal with it. The subject is a
complicated one, partially because policy toward unemployment
cannot be formulated in isolation from a number of other important
issues. Three important related topics are:
1. Inflation. If unemployment is such a bad thing, then why can©t
the government simply hire people who are out of work? Alterna
tively, why can©t the government increase the level of aggregate
demand so that private firms will hire more people? As we shall see
below, one of the major controversies in macroeconomics is whether
1
2 The Conflict Between Equilibrium and Disequilibrium Theories
government spending policies can have any impact on unemployment.
But it is fairly well agreed that a by-product of government spending
policies to decrease unemployment is wage inflation. Hence, one
important issue we address is how to estimate the trade-off between
inflation and unemployment.
2. Taxes. In discussions about unemployment, the subject of tax
policy usually arises in two related but distinct contexts. The first is the
effect of taxes on aggregate demand. For example, does lowering
income taxes induce consumers to spend more, perhaps leading to
more employment? The second is the effect of taxes on aggregate
supply do tax decreases affect the amount of work people want to
do? If so, can the additional labor supply be absorbed by the economy
in a reasonable amount of time? Both of these effects are important and
interesting. However, the primary focus of this essay is on the
workings of the labor market rather than the determinants of aggregate
demand, so we will consider mainly the supply effects of tax changes. 3
3. Unionization. It is usually argued that unions increase unem
ployment by raising wage rates above their equilibrium level. It could
be, however, that the main effect of unions is to reduce the supply of
labor, i.e., to shift back the supply curve. This would have the effect
of decreasing unemployment. Because both effects might be operative,
the outcome is theoretically ambiguous. Indeed, in their very careful
analysis of U.S. employment data, Pencavel and Hartsog (1984) find
that when it comes to the effect of unionism on relative man-hours
worked, the data do not unambiguously point to a negative effect, (p.
217) Our analysis allows the unionization rate to influence the
unemployment rate in several different ways; the data determine
whether the effect is positive, negative, or zero. We also estimate how
changes in the unionization rate would affect the unemploymentinflation trade-off.
1.2
The Methodological Issues
Given its evident importance, economists have focused a massive
amount of attention on the problem of unemployment. Unfortunately,
no consensus has been reached on its causes. A fundamental contro-
Introduction 3
versy in the profession is whether unemployment is better viewed as an
equilibrium or a disequilibrium phenomenon. Although one may argue
about the precise connotation of "equilibrium," for operational
purposes we take it to refer to a situation in which prices immediately
clear markets: prices are such that neither buyers nor sellers have any
reason to attempt to recontract. Applied to the labor market, this means
that at each instant the wage rate adjusts so that the supply and demand
of labor are equal.
In contrast, the disequilibrium approach views prices as rigid or at
least sticky they do not adjust instantaneously to equalize supply and
demand. Hence, suppliers or demanders may have to be rationed, i.e.,
they cannot obtain as much of a commodity as they desire at the current
price. In a disequilibrium labor market, the prevailing wage may be
above or below the wage that would equate demand and supply. 4
Both approaches have advantages and disadvantages. The notion of
equilibrium is a cornerstone of economics. It is an enormously useful
concept that has permitted a variety of important comparative statics
analyses of micro as well as macro phenomena. However, applying the
equilibrium paradigm to the analysis of labor market fluctuations leads
to an obvious problem if the supply and demand of labor are always
equal, then why is there any unemployment? As Altonji (1982) points
out, according to modern equilibrium theorists, the main reason is
intertemporal substitution:
In essence, the [equilibrium] hypothesis explains cyclical
fluctuations in employment and unemployment as the re
sponse of labour supply to perceived temporary movements
in the real wage. The key behavioral postulate is that leisure
in the current period is highly substitutable with leisure (and
goods) in other periods. Consequently, movements in the
current real wage . . . elicit a large labour supply response,
(p. 783)
In short, some individuals may choose unemployment this year
because they believe that they will be able to earn more next year. Is
this a sensible story? Critics of the equilibrium view find it implausible
that during the Great Depression 25 percent of the workforce was
unemployed only because so many people (mistakenly) believed that if
4 The Conflict Between Equilibrium and Disequilibrium Theories
they waited a while, they would command a higher wage rate.
Nevertheless, proponents of the equilibrium view argue that it provides
a good explanation of the historical data. (See, e.g., Lucas and
Rapping 1970.) On the other hand, other econometric tests of the
equilibrium hypothesis are not very favorable to it. (See Altonji 1982
or Mankiw, et al. 1982.)
In contrast, the disequilibrium formulation appears to accommodate
the phenomenon of unemployment with relative ease the wage rate is
"too high;" workers without jobs would be happy to work for less, but
the wage rate will not fall or, at least, will not fall sufficiently to clear
the market. But denial of wage flexibility, simple as that notion may
be, brings with it a host of difficulties in model specification and
estimation. For example, why do firms pay workers more than the
wages required by their potential replacements? After all, by defini
tion, those who are involuntarily unemployed would be willing to work
for a wage less than the prevailing one. In short, failure of markets to
clear is generally viewed as concomitant with the failure of some
agents to optimize.
However, under certain conditions sticky wages can be the outcome
of optimizing behavior by both firms and workers. For example, the fact
that firms do not always take advantage of opportunities to replace
workers with cheaper replacements may be due to costs of labor turn
over. Several more sophisticated theoretical attempts to rationalize
sticky wages are discussed in section 2.2.3 below. Whatever the success
of such theoretical exercises, however, proponents of disequilibrium
models are apt to point out that despite difficulties in explaining pre
cisely why the labor market does not clear at every moment in time, the
real world does seem to be like that, and this fact should be reflected
in economic analysis. As Rees (1970, p. 234) observes,
Although we know very little about the exact nature of the
costs of making wage changes, we can infer that they exist.
Wages are, next to house rents, the stickiest general class of
prices in the economy, seldom adjusted more frequently than
once a year. This stickiness may be reinforced by unionism
and collective bargaining, but it was present long before
unions arrived.
Introduction 5
The debate between protagonists of the equilibrium paradigm and
the disequilibrium paradigm has a strong ideological flavor. Propo
nents of one view frequently think that the alternative view is worthless
or perhaps downright silly. A few years ago, one of us gave several
seminars on the question of how one would test the null hypothesis that
a set of observations is better explained as having been generated from
an equilibrium as opposed to a disequilibrium specification. On some
of these occasions (mostly in the U.S.), five minutes into the seminar
it would be interrupted with the remark, "What you are trying to do is
silly, because everybody knows that prices always clear markets and
therefore there is nothing to test." At other times (mostly in Europe)
the interruption took the form, "What you are trying to do is silly,
because everybody knows that prices never clear markets and therefore
there is nothing to test." Juxtaposing the two remarks very much
convinced us that there definitely is something to test, and that any
approach that is not ultimately willing to subject such questions to data
as the final arbiter must be misguided.
1.3 Goals of this Monograph
The equilibrium vs. disequilibrium controversy is not only a matter
of methodological interest. Appropriate answers to the important
policy problems discussed in the first part of this chapter will depend
in part on whether an equilibrium or disequilibrium characterization of
the labor market is more appropriate. The goal of this essay is to
estimate both disequilibrium and equilibrium models of the U.S. labor
market, and to compare the results and their implications for policy. To
our knowledge, this is the first attempt to estimate and compare fairly
sophisticated equilibrium and disequilibrium labor market models.
A great deal of work in the U.S. labor market has followed the
equilibrium paradigm. The economic and statistical issues associated
with such models are now well understood, and there is no need for
them to be exposited here at great length. In contrast, there has not
been a great deal of work based on the disequilibrium paradigm. 5 We
shall therefore devote a disproportionate amount of time to discussing
6 The Conflict Between Equilibrium and Disequilibrium Theories
the problems that arise in formulating and estimating a disequilibrium
model.
Chapter 2 discusses equilibrium and disequilibrium approaches to
labor market analysis, with special focus on policy implications. In
chapter 3 we specify the disequilibrium model, and in chapter 4 the
results are presented and discussed. Chapter 5 contains the equilibrium
model. Chapter 6 concludes with comparisons between the disequili
brium and equilibrium results, and some suggestions for future
research.
NOTES
©This calculation was done using "Okun©s Law," which states that for each
1 percentage point reduction in the unemployment rate, real GNP will rise by
2.5 percent. If the actual rate of 7.1 percent had been reduced to an assumed
"natural rate" of 6.0 percent, then Okun©s Law implies an increase in real
GNP of (7.1 - 6.0) x 2.5 = 2.75 percent.
2For a careful discussion of the crime issue, see Massourakis, et al. (1984).
3For a discussion of the influence of tax changes on aggregate demand, see
Blinder (1981).
^©Disequilibrium" has often been construed to refer to a state in which
forces are at work to restore the system to equilibrium. This interpretation is
not intended here, since the state of disequilibrium may persist indefinitely.
For this reason, disequilibrium in the present sense is sometimes called a
"fix-price equilibrium."
5For some examples, see Rosen and Quandt (1978), Romer (1981), and
Artus, Laroque, and Michel (1984).